Sunday, May 21, 2017

Berkshire - Hathaway & Sequoia Fund: As Seen Through Alphabet, Amazon, and Apple



 Introduction

For the week that ended Friday one could focus on short-term price movements or long-term investment thinking. As my week evolved I did both, which produced positive, but disjointed conclusions.

Short-Term Price Actions

On Thursday prices fell supposedly in reaction to political events. As an analyst and portfolio manager trained in the school of contrarianism, I saw the reason for the decline differently. For some time I have been aware and have commented on the price gaps in the performance of the three main individual security price indices; Dow Jones Industrial Average, Standard & Poor's 500, and the NASDAQ composite. In each case the index had two days when  prices through the day were measurably higher than the high price achieved the day before. This price gap phenomenon rarely happens and most of the time a subsequent price action fills the gap before the market resumes its prior trend. In earlier blogs I had warned about this probability. Further, I quoted a knowledgeable market analyst who was expecting a 5% correction.

On Thursday the two price gaps in the two senior indices, DJIA and S&P 500 closed both gaps. By far the strongest index this year, the NASDAQ closed one. I would expect in the fullness of time the remaining price gap will be closed. Historically when the bulk of traders focus on the political issues of the day (in contrast to the financial inputs) their emotions are a bad guide to future investment price performance.


A less followed sign is the Confidence Index published by Barron's each week. The index focuses on the difference in yields between the highest corporate bonds and those of intermediate quality. In the week ending Friday, compared to the prior week, high quality bonds yielded 3.22%, down 17 basis points whereas the intermediate credits yielded 4.27%, down only 13 basis points. This suggests that in the week high quality bonds were considered better value than the higher yielding intermediates. Often this is considered a bearish sign for equities as bond buyers are opting for lower risk securities.

In assessing the value of these two observations it is important to understand that the judgments expressed are based on a feeling for the historical odds and not certainties. As noted in my earlier blog posts there are no pure laws of economics that guaranty the same level of certainty as found in physics. One should assign perhaps a 90% certainty to your favorite economic laws. Most so called "investment laws" would be considered successful if they were correct 70% of the time. Using a technique I learned at the racetrack, I multiply these ratios (0.9 x 0.7 = 0.63). This suggests to me that I would be happy if my analysis was correct 63% of the time. I can improve my dollar return by weighting some decisions compared to others.

General Sun Tzu

Other than the Bible no other text has been used more to teach the military than Sun Tzu's "The Art of War. Considering the importance that we are putting on the rapid progress of China it is very wise for us to remain conversant with China's greatest military scholar. Friday I was refreshed in my knowledge of the general's thoughts when good friends of mine who are life long investment experts on Asian investing gave me a book by Jessica Hagy, The Art of War Visualized: The Sun Tzu Classic in Charts and Graphs.

Since in many ways competitive investing follows the equivalent precepts as successful military warriors, I am going to apply the same principles to investing. There are five particular strategies that the General recommended.

1.  Victory can be achieved through measurement, estimation, calculation  and balancing chances. (In investing it is important to measure accurately what is there and even more important what is not there; e.g., BREXIT and the Republican swing, as well as incomplete financial statements.) These are some of the times when good estimates are critical which makes it essential to know how much reliance to place on calculations of the future. In discussing the short-term data above I showed one possible way to calculate different levels of uncertainties. All of these and other factors need to be weighed in conjunction to determine whether the odds of success are sufficiently high to undertake the risk to achieve victory.)

2.  Always be prepared to attack and always be prepared to defend. (Opportunities will always occur without warning.) A good investor must be able to quickly shift to an aggressive mode and just as quickly shift into defense. Most investors have too little in the way of reserves to dramatically "juice" returns, particularly if they are reluctant to sell or reduce less favorable positions in the new opportunity context. In terms of defense we all need to part with some of our least loved positions regardless of tax implications.

3.  There are dangers to be avoided: recklessness, cowardice, hasty temper, and rich appetites. (Many will find it difficult to react wisely to the opportunities due the dangers listed. As is often the case we can be our own worst enemy. The General called for sound discipline at all times.)

4.  Do not feel safe and be a good generalist full of caution.  (Quite possibly the biggest risk to our wealth is a feeling that we are safe. We are not on the outlook for possible problems, most of which won't materialize, but some or one can be like a hole below our boat's waterline. This can be caused by our bad navigation or an enemy torpedo, Perhaps at least mentally we should practice fire drills as well as abandon ship actions.


5.  An experienced General is never bewildered. Once some level of activity is commenced it is easier to accelerate or decelerate than to start to move from a standing stop. I am a believer, at times, of making partial commitments and at other times full actions. Often the key to an investment decision is not the action itself but how it positions a person or portfolio for subsequent steps.

How Sun Tzu Might Have Viewed the Actions of Berkshire Hathaway and Sequoia Fund Through Alphabet, Amazon and Apple


One is always at risk of misinterpreting or over simplifying by abbreviating some of  The General's thinking. For this exercise I am only going to focus on his first step to victory through calculation and his fourth, balancing chances. Almost all of the named securities (Alphabet, Amazon, and Apple) are owned by me or close relatives. However, the purpose of the ensuing observations are not meant to be taken as any form of recommendation. For those who are interested in converting the observations into actions, I will be happy to discuss my views tied to your specific needs, “off line.”

Berkshire and Sequoia share the same source of inspiration, Warren Buffett. Not surprising over the years they have owned some of the same stocks derived from their own work. The three highlighted stocks were recently discussed in investor meetings. The reason to focus on these three specific stocks is that it revealed their thinking.

Alphabet, the parent company of Google, was well known to both. Mr. Buffett’s view is one that was under its nose as it was extensively used by Berkshire’s subsidiary GEICO. It was just not in its universe, which is strange as GEICO is so advertising-centric (both they and I owned Interpublic one of the largest global advertising complexes recovering from very poor results). As it wasm't looking at Google, it was not in the calculation. This is similar to those who were following the polls prior to the BREXIT and Trump votes in analyzing data, perhaps the most important task is identifying what is not there.

To some degree Sequoia also had a calculation failure. Sequoia quickly grasped the advertising power that the Google search engine produced. However, it needed a "kicker" to be added to its calculation. The kicker was "AI" or artificial intelligence. Sequoia believes that Alphabet is "by far" the leader in AI, which it may be. My problem is that the current level of earnings from AI products or augmented services has not been revealed. In this particular case the lack of numbers on the AI effort was probably a factor in its balancing of chances.

Amazon is another example where the two intrinsic value investors disagreed. Because of Berkshire's operating experience it had some doubts that Jeff Bezos could succeed in the highly competitive distribution business. If he could succeed, it doubted that the same mentality that could build a highly successful distribution business could aptly handle the technologically challenging task of developing a commercial cloud business. I suggest that the financial analysts in Berkshire focused on the financials which showed robust revenue growth and marginal reported profits. Sequoia saw that the financial statement hid the internal process of taking substantial operating profits and reinvesting them into the cloud. Further, Sequoia probably saw that the keys to the success of Amazon's distribution business were based on highly automated warehouses and tightly controlled transportation. However, Sequoia like many of us, were captured by its collective experience. Bill Ruane the founder along with Rick Cunniff often focused on buying stocks "at the right price" and thus they did not buy as much as they should have as the price of Amazon went up.

Apple is another example where these two investment groups came to different conclusions based on their research methodologies. Sequoia in calling on Apple's management, could not get them to speculate what handset sales would be three years in the future, so they passed. Again the words of its founder were a hurdle. Bill said that they understood potato chips not computer chips. Berkshire only recently viewed Apple as a consumer not a technology company. They focused on both the "eco-system " that Apple was growing and the potential use of its technology and related skills in substantially new product categories not yet on the market. Interesting that both Berkshire and Sequoia want to invest in companies that have competitive advantages, which is often translated into unique products or services. Sequoia will sacrifice future growth for competitive advantage. Berkshire under Charlie Munger's prodding is more attracted to growth at a fair price. Apple effectively used the General's formula of balancing chances.

Bottom Line

As with all "school solutions" there is no guaranty of success. While the odds improve with a well thought out plan, nothing beats good execution. Thus, when we pick mutual fund and separate account managers we pay attention to both their investment philosophy and their history of good executions. More often than not good executions are the results of front line troops. That is the lesson that I learned as a US Marine Officer where it was my job to develop a plan of action and inform my senior non-commissioned officers of the plan and the logistics, communication, and heavy arms support, but let them carry out the mission as they saw how to do it. The same principle works at the racetrack. While I did not see the running of the Preakness the two horses that were leading coming into the homestretch had a good plan, but a third horse had a better execution and thus won the race.

As you can see I am always learning and hope to do so all of my intellectual life.

What are the sources of what you have been learning recently?
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A. Michael Lipper, CFA
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Sunday, May 14, 2017

Implications of China vs. US Timespans



Introduction

A number of years ago a good friend attended a Chinese Embassy party where a very senior member of the government commented that while the West owned the watches, the Chinese owned the time. This critical distinction has stayed with me in terms of looking at investment horizons.

One Belt One Road

While there has been some US coverage of the “One Belt One Road” meeting in Beijing this Sunday hosted by Xi Jinping with Vladimir Putin in attendance, most of the US attention has been focused on the dismissal of one employee at the discretion of the President. As a long-term investor, I believe this is a misplaced focus. On the Chinese side the implications of the massive One Belt One Road Initiative may have implications into the next century. The US focus appears to be on the electoral contests in 2017-2020.

I find it is interesting that China is using a staging investment philosophy somewhat similar to our TIMESPAN L Portfolios®. China announced some of the outlines to this the One Belt One Road Initiative in 2013. From an economic vantage point it was a brilliant way to export its excess steel and cement capacity in building long line railroads and some internal subway systems. It also would reduce shipping costs of Chinese manufactured products that potentially could be exported to 60 countries, part of the land and sea bridges.  This is somewhat like President Eisenhower's US interstate highway building program that required new federal highways to be built with the ability to handle the transportation of heavy tanks.  As the rail and port facilities are built, China (even without moving its military) will have strengthened its ability to influence all of the surrounding countries. Some have called this drive as "Globalization 2.0.” Compared to the Russian leader in attendance, the US is sending a senior director for Asia at the National Security Council. While there is definitely a military threat in this initiative, by far the bigger threats are economic and political.

The One Belt One Road Initiative is not without substantial  risks. The planned funding requires a series of public/private partnerships. Every analyst and most investors should have knowledge and respect for past histories. Around the world in the last half of the 19th Century, there was a surge of railroad building. The British were particularly active in South America. I suspect that almost every railroad company started during this period eventually went bankrupt. In one case the largest and most powerful UK merchant bank almost went under because of its Latin American exposure. I can not think of a long line US railroad that did not enter or threatened to enter bankruptcy. Some of the same problems exist today. One of the Chinese-backed African rail lines is not expected to reach breakeven for the first eleven years, and we all know how reliable the predictions of breakeven have been. 

If we of short memory fail to remember the global distribution of less-than- healthy US residential mortgages, we could have a replay with global distribution of private partnerships through the growing power of Chinese financial services companies. Thus, for the global investor there is both downside and upside as this initiative grows. I maintain that no matter what you invest in; stocks, bonds, commodities, real estate, currencies, or intellectual property, your returns could pivot on what is happening or rumored to be happening in China.

What are the US Markets Focused On?

Investors into the US market are focused on the very short-term to intermediate future while China is exercising its long-term options.

The following are briefs tidbits that have crossed my computer screens this week:

1.  Dow Jones Industrial Average - A minuscule decline closed on of the two price gaps in its current chart. The other two major stock indices, S&P 500 and NASDAQ, still have price caps. (One wise market analyst suggests that we need a 5% decline before we can resume a meaningful upturn.)

2.  JP Morgan has noted that 37% of NYSE volume is executed in the last half hour of the trading day as Index funds rebalance.

3.  There is some justification in the adage “Sell in May and Go Away.” Since 1950, the period November through April does better than the other six months, 71.64% of the time.

4.  According to its inventor, the CAPE ratio, used as a valuation measure, explained about 1/3 of the variation in the ten year returns. (Surprisingly this is roughly the same chances of a favorite winning in most horse races.)

5.  Ray Dalio, who manages one of the largest hedge funds, sees no major economic risk in the next year or two. (This could be an important cautionary flag.)

6.  The highly respected GMO seven year prediction for real return on stocks is -3.8%

7.  Vanguard believes we are in a period of slow growth; e.g., a 60/40 asset allocation will produce a return between +3% and +4.5%. (If they are correct, which I doubt, the average foundation will be liquidating its base each year if it has a mandated 5% pay out.)

8.  Turning to the increasingly popular European investing, there are two points worth considering: (a) the current price of the Stoxx 600 Index is where past rallies have peaked out, and (b) over half of the ETF flows into non-domestic funds came into three Index funds and these were somewhat smaller than the ETF redemptions in two domestic Index funds. (These suggest to me that main players in the ETF market are trading-oriented, and may not be patient during surprises.)

Investment Conclusions

Despite the reputation of highly speculative retail Chinese investors, the Chinese government is playing a long game.

The US market is increasingly short-term focused. This may, over time, give us longer term investors a bigger barrel to fish in.

As we structure various markets I am wondering whether our assorted valuation measures need to be adjusted due to fundamental changes in supply and demand.

Any thoughts? 
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A. Michael Lipper, CFA
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Sunday, May 7, 2017

We are All Odds Players



Introduction

Sam Zell, Charlie Munger, Warren Buffett, The Kentucky Derby betting, and the  laws of economics were this week's input to my investment thinking. The common theme of my reactions to each of these inputs is that an understanding of odds leads to better investment decisions.

Odds

Odds are the generally expected returns on successful execution of an action. Every single thing we do is premised on the conscious or unconscious expectation starting with our getting out of bed in the morning. Either we accept the odds set by others or we believe that there will be a higher payoff than generally expected.

Sam Zell

I had the pleasure of attending "A Conversation between Lee Cooperman and Sam Zell" at The New Jersey Performing Arts Center last Thursday night. Sam is a very much a self made billionaire through many entrepreneurial ventures largely built around real estate. Similar to our friends at Marathon in London, he is a believer in the capital cycle. They are attracted to investment opportunities when capital has been removed and are sellers when there is a rush of new capital entrants. They like unique assets where there is limited competition. This is not real estate today. As a singular buyer, he has improved his odds. (He is the chair and a large shareholder of a non-real estate public company with limited competition in which I happen to own a few shares.)

Charlie Munger

Charlie Munger's family hold a large family dinner the Friday night before the Berkshire Hathaway annual meeting. He has been a major educational input to his senior partner, Warren Buffett which Warren states is one of the reasons for many of the successes of the company. I am combining Charlie's comments at the dinner and at the meeting which can be summarized below:

  • Learning is the key to their success. They have learned from their numerous past mistakes. Warren is a learning machine. Proof of his learning is the Apple purchase.




  • Charlie would be willing to put $150 Billion to work if they had the right opportunity.



  • China will do very well in the future due to the character of the people.



  • As a business, BYD is building well in terms of people and products. Looks for big returns with favorable odds.

  • Warren Buffett

    One of my sons and I go to the Berkshire Hathaway annual meeting with perhaps 40,000 others. We view this as a learning experience as to investing principles and a review of business conditions at the entrepreneurial level. While it is difficult to summarize five and half hours of questions with some answers, there were a number of points made that were useful to us as portfolio managers shown below:

  • They look for competitive advantages. Often they are the only choice for an entrepreneur who wants to sell a private firm, that wants to take good care of loyal employees.




  • Medical costs are the tapeworm that is growing in corporate expenses.



  • In 2017 there is a slight bias in favor of recognizing losses.



  • Trying to be a genius is dangerous.



  • Opportunities are more difficult to find.



  • The five largest operating companies within the S&P500 generate enough capital that they do not need any new equity capital.



  • Very, Very IMPORTANT: In some cases Intellectual Capital may be more important that Financial Capital. I also suggest customer capital in terms of relationships(at least in the financial services businesses) should be valued more the cash capital.

  • Betting on The Kentucky Derby

    I was asked who to bet on in the historic Run for the Roses race. I had not the time or the inclination to spend time on handicapping or analyzing these immature three year old horses in the spring. However, I did say that the horses that had odds of around 5 to 1 made sense and that at least one of the three top finishers would be a long shot. The table below shows the payoffs on a two dollar bet in each of the winning pools-to win, place, or show:

    The Winner
    $11.40
    $7.20
    $ 5.80 
    Second

    $26.60
    $18.20
    Third   


    $20.80

    For investors the importance of this table is not that I was conceptually correct, but it illustrates the importance of odds to making money. Often one can make twice as much on betting on long shots to do almost as well as the winners. (For those track aficionados my analytical bet for the 2018 race without knowing who is running is that the favorite will not win. After five straight years of the horse with the lowest odds winning, I am guessing that a horse with greater odds than the most popular horse will win. This is similar to the exercise of looking for attractive stocks to buy for the next year by studying the new low list rather than the new high list.)

    However not every long shot has the same chance of doing well. The third best horse was never worse than fourth out of twenty throughout the race. While the second best got up to second best by the beginning of the final stretch drive. In picking horses and stocks the odds is not the primary filter to make money but a reasonable analysis that the horse or company behind the stock can be successfully positioned to do well. In both cases picking unpopular horses or stocks is based on a somewhat courageous view to bet against general perceptions, being a contrarian by nature I am willing to explore such a bet. However, it is important to understand that just like in The Kentucky Derby, favorites do occasionally win.

    Are There Any Laws and Constants in Economics?

     A Brief Comparison to the Sciences:

    One of the advantages I have is to be a member of an informal investment group of retired and semi retired analysts, portfolio managers, and institutional sales people who regularly share ideas and research. The above titled article from the Journal of Contemporary Management by Harold Vogel was recently circulated. What does this erudite article have to do with the concept of odds? The connection is that the author does a good job showing the various "laws" and "constants" that various economics proclaim don't hold to the same level of rigor we expect from scientific laws. In essence these so-called laws and constants work some of the time, maybe even most of the time. Further, it is reasonable to expect that there will be some conditions in the future when they may not work. Thus, it would be wise to view these inputs through some lens of probability or under my construct, odds. This is particularly important as various central banks and government officials treat these as immutable laws that will always work. This has not been the case in the results of either our fiscal or monetary policies.

    As bad as the "dark science" of economics has been, the impact of its errors when applied to investments is much worse. Conceptually, the error rates of the economists are multiplied by professional investors. To protect us poor investors I suggest that we should develop a mechanism of putting some odds around the different proclamations of well known economists and investment pundits. These proclamations should not be totally ignored because we have just shown that popular views as measured by favorites at racetracks do occasionally win. Nevertheless, my approach is to construct odds or if you prefer, discounts, to various public statements.

    Putting Odds on Where There is No Experience

    The current editions of one of my favorite magazines, Barron’s has a cover story entitled "Income: The Best ETFs for Yield.” I have no problem using a collective vehicle as a way to invest in fixed income. This is becoming very popular. According to my old firm, iBoxx $ 1 G Corp Bond ETF had the highest net inflows of the week of all ETFs, totaling $412 million.

    My concerns are first that the ETF trades many times a day, some of the underlying bonds trade rarely. While the popular press thinks most of the flows around ETFs is from individual investors, I suspect most of the trading is done by institutional investors, often hedge funds and other professional traders. Often these trades are done in combination with other trades combining long and short positions. This is a cheaper way to do these trades than through their prior habit of using futures. Except in the special case of Vanguard who has been able to create an ETF class in their low cost open end funds, most of the other funds can't absorb a large amount internally, they will have to find a buyer for the ETF's selling specific bonds.

    In addition, most ETF transactions pass through "Authorized Participants" who act as did the old specialists did on the floor of the stock exchanges. There are often a small number of "APs" for each ETF. These dealers often make markets in other securities as well. The old specialists used to have known levels of capital which was closely supervised by the various exchanges. These artifacts don't seem to be in place in today's world.

    My concern is that at some unknown point in the future the major hedge funds and other traders will feel compelled to quickly liquidate their fixed income and perhaps other thinly traded security ETFs. Some of the thinly capitalized ETFs can not absorb the sudden waves of selling at the same time  the sponsors of the ETFs can not absorb the continuous waves of selling.

    It is important to declare this has not happened....yet. But it did to the old single stock specialists on the floor of the exchange. My concern, just like various economic laws and constants not working, there could be a liquidity crisis in the ETF world.

    My suggestion is that wise investors assign some chance of this event and monitor the relevant conditions.

    My Investment Conclusions

    As every single thing we do involves some chance of favorable and unfavorable results to develop an awareness of chance or odds, I recommend building investment portfolios with different odds of positives and negatives. This approach may generate uneven statistical results, but its most important characteristic is focused on the need to survive under numerous difficult conditions.

    What do you think?
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    A. Michael Lipper, CFA
    All rights reserved
    Contact author for limited redistribution permission.